A separate taxable estate is created when an individual files Chapter 7.

A Chapter 7 trustee is not going to pay secured creditors unless he happens to sell an asset.

Conversion gotcha’s

Two practical and tangled issues have come to the fore in our conversions recently, ones that I don’t think I adequately prepared the clients for.

The first is the car that was being paid through the plan.

Unless conversion comes after all contractual payments were made in the Chapter 13, the deal reverts to prepetition terms. You are back to contract interest rate and contract monthly payments.

Chances are high that the debtor isn’t current to the contract.

If the debtor expects to reaffirm the car loan, a standard question of judges reviewing reaffirmation agreements is “Are the payments current?“. A negative response doesn’t bode well for reaffirmation.

Forewarned is forearmed.

Alert your client to the issue. Get them paying ASAP.

Be in contact with the lender. Find out what the deficiency is, if any.

Negotiate the reaffirmation to declare the debtor current to the reaffirmed deal.

The second gotcha that has bitten a couple of converted clients recently is the penalties and interest on priority tax claims. In the 13, the priority taxes were being paid, and even the penalties on those priority taxes were dischargeable in Chapter 13.

Penalties on taxes less than 3 years old are not dischargeable in Chapter 7. Section 523(a)(7) excepts from discharge debts…

to the extent such debt is for a fine, penalty, or forfeiture payable to and for the benefit of a governmental unit, and is not compensation for actual pecuniary loss, other than a tax penalty—

(A) relating to a tax of a kind not specified in paragraph (1) of this subsection; or

(B) imposed with respect to a transaction or event that occurred before three years before the date of the filing of the petition;

Generally, the taxing authorities apply payments to the tax first, then to interest and then to penalties. Chances are “good” that if the Chapter 13 plan included priority taxes, the debtor will emerge from the Chapter 7 owing penalties as well as any unpaid tax.

Managing expectations

Good lawyering can’t change the law that creates these tangles in a converted case.

But alerting the client to the issue ahead of time saves you from the familiar whine: you didn’t tell me….

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About Cathy

I'm a certified consumer bankruptcy specialist, Northern California chair for the National Association of Consumer Bankruptcy Attorneys, on a mission to help lawyers become better bankruptcy practitioners.